Transaction costs
Investors are constantly looking for ways to reduce the costs of managing money. These efforts usually focus on reducing management and performance fees since this is the bulk of the costs. According to a 2018 analysis of CEM Benchmarking amongst 19 pension and sovereign wealth funds with combined assets of more than £2tn, the average total cost pf managing money were 86.3 bps, 62.2 bps of which (73%) were due to management and performance fees.
However, transaction costs, such as brokerage costs, taxes, spreads etc. account for 20.2 bps or 24% of total costs. And this cost factor is often ignored in favour of reducing management fees. Just like the analysis of fees typically focuses on alternative investments as the main culprit, the knee-jerk reaction of investors is to point to the high transaction costs for alternative investments (in particular in private equity and private debt) as the main driver of this cost. But as the study shows this is not true.
While transaction costs for hedge funds and private equity/debt are quite high, their low allocation in the average portfolio and the typically long holding periods for these investments mean that effective transaction costs are not that high. In comparison, fixed income holdings comprise an average of 31% of the portfolio in the CEM Benchmarking study but the average transaction cost per year are a whopping 21.9 bps. This means that 6.8 bps of the 20.2 bps transaction costs are due to fixed income holdings. OTC derivatives add another 3.4 bps simply because the notional amounts for interest rate swaps etc. are so high that even small spreads create significant costs for the overall portfolio. The end result is that fixed income and fixed income derivatives together account for 10.7 bps of the 20.2 bps in transaction costs incurred per year. In comparison, hedge funds and private equity account for 5.9 bps in transaction costs per year and real estate and infrastructure for a combined 1.2 bps. The allocation to fixed income is about twice the allocation to real estate and infrastructure in the examined portfolios, yet the transaction costs incurred by the fixed income part are ten times as high as the transaction costs incurred by real estate and infrastructure investments.
Transaction costs in bps for 19 large pension and sovereign wealth funds
Source: CEM Benchmarking.